The Market Goes Down, but Is Far From Out

Stocks continue to be under pressure, with the S&P 500 yesterday reaching its lowest levels since early April. However, the market then rallied yesterday afternoon and today.

Value stocks, which initially held up well when the decline started in September, began to feel pressure as concerns shifted from higher interest rates and slowing growth among technology shares to the state of the global economy in 2019. While there are no economic indicators pointing to immediate problems in the United States, rising corporate bond yields have investors concerned, considering the large amount of debt that was raised while interest rates were very low.

Over time, this could lead to tighter lending conditions at banks, which will impact economic growth. In addition, the weakening economy in China, where auto sales plunged for five straight months and trade weakened considerably in November, amid falling consumer sentiment in Europe, has led to doubts about the global economic outlook for 2019.

EPS estimates for the S&P 500 for 2019 of $176.51 per share, up from $162.42 this year, are likely to be high, if for no other reason than they have not factored in the decline of oil prices. The oil price drop will take a toll on the earnings of energy stocks.

However, it would be premature to write off any hope of earnings growth in 2019. It was very encouraging last Friday that Illinois Tool Works (ITW), a bellwether for the health of the global economy given its large size and exposure to many industries, forecast organic growth of 2% to 4% in 2019. I still feel, as we begin fourth-quarter earnings season, that many companies will be optimistic about 2019. While current estimates for S&P 500 earnings are too high, perhaps $170 per share is realistic. Given such earnings, along with the Fed nearing completion of its tightening cycle, a return to the market’s old highs next year is a possibility.

With the recent selling, the Russell 3000 Value Index entered today with a 4.6% decline for the year. We certainly have taken some lumps with the market recently. However, we preserved profits we made earlier in the year, and our average position including sales is up 1.59% before today’s open. I do think our current Recommended List is well positioned for the start of 2019, especially as some of the economic fears fade, which I think they will. However, I will remain on the alert for potential changes in this dynamic environment and will adjust as necessary.

Now let’s take a closer look at our two most recent additions to Value Authority, Party City and Children’s Place Inc.

The Party is Just Getting Started

Party City is the largest party goods and Halloween specialty retailer by revenue in North America, operating over 900 company-owned and franchise stores. The company also designs and manufactures party goods found in more than 40,000 stores worldwide.

In 2017, retail operations contributed 73% of total net sales, while the wholesale operations contributed the remaining 27%. The company also collected $13.5 million in royalty revenues in 2017, although this number will decline as Party City is acquiring its franchised stores.

PRTY had its IPO in April 2015 at $17 a share, when private equity firm Thomas H. Lee Partners sold a little less than half its shares. EPS has been very consistent since the IPO, rising each year from $0.92 in 2014 to $1.24 last year. The company is currently guiding EPS in 2018 to $1.60 to $1.65 for 2018. However, the gains are strictly due to a lower tax rate due to tax reform and a large repurchase of shares from Thomas H, Lee, which has reduced the total share count by 20%. The company is projecting earnings before interest, taxes, depreciation and amortization (EBITDA) to be roughly flat at $410 million for the year.

While the stock has been under pressure since July on the disappointing operating results and continued concerns about price deflation for costumes, I believe the selling is overdone. The disappointing results this year were largely due to the Chinese tariffs, which disrupted helium and latex supplies. But this situation should not be as big a problem in 2018, regardless of the outcome of trade talks as industry participants have made adjustments that will prevent the supply shortages of this year.

At just 7X this year’s EPS estimates and just over 6X Enterprise Value to EBITDA, the stock seems to be pricing in a lot of earnings risk, even as some of the biggest concerns about Halloween pricing do not seem to be occurring. The company will use its significant free cash flow to continue to buy back shares and reduce debt to build shareholder value. While I wish the company would emphasize debt reduction as opposed to share buybacks with its free cash flow, management said it can accomplish both. Debt is currently 5x EBITDA. Management said it aims to trim it to 3.5X by 2022.

While PRTY is trading off its worst levels of the year, it also is well below its highest levels, and I look for the shares to do very well in the first half of 2019. Party City is a buy below $10.50. My target is $16.

Invest in a Stock that Offers Much More than Mere Child’s Play

The Children’s Place is the largest children’s specialty apparel retailer in North America. The company designs, contracts to manufacture, sells at retail and wholesale, and licenses to sell fashionable merchandise at value prices, primarily under the proprietary “The Children’s Place,” “Place” and “Baby Place” brand names. As of November 3, 2018, the company operated 988 stores in the United StatesCanada and Puerto Rico. The company also has 211 points of distribution run by eight franchise partners in 20 countries. International Sales contributed 11.7% of the total in fiscal 2018.

The company has four strategic initiatives in attempt to drive success. The first is product, Children Place’s biggest priority. The company attempts to have the right product in the right channels of distribution at the right time. PLCE also offers accessories and shoes to allow a busy mother to buy a complete outfit for her child in one visit. The second is business transformation through technology, especially investments in inventory management and developing and implementing a personalized customer contact strategy to deliver personal content that will help drive more store traffic. The third initiative is to continue to grow alternate methods of distribution, including its ecommerce site and its international franchise partners. Finally, the company will continue to optimize its store base, such as its decision a few years back to close 300 stores. A little over two-thirds of these stores will be closed by the end of the fiscal year.

Children’s Place has enjoyed solid growth in recent years. Sales were up 3.4% and 4.8%, respectively, in the January 2017 and January 2018 fiscal years. Management attributed the success to strong consumer response to its unique product offerings. Since the company was closing stores at the time, comparable store sales were even higher, increasing 5.8% in fiscal 2017 and 4.9% in fiscal 2018. This was very profitable growth, with EPS increasing from $3.60 in the January 2016 fiscal year to $7.91 in the January 2018 fiscal year. Margins expanded on the higher volume and the elimination of less profitable stores. In addition, EPS comparisons were helped by a 10% reduction in outstanding shares as the company bought back shares.

When the company reported fourth-quarter results for fiscal 2018, it expected EPS gains to slow due to investments in growth initiatives. However, it did set a goal of $12.00 a share in EPS in the fiscal 2021. While the stock was volatile throughout the year, it did reach close to an all-time high near $160 a share in early October before the market sold off. The stock gave up further ground last week when, after reporting third-quarter earnings, the company lowered EPS guidance to $7.69 to $7.79 a share from $8.09 to $8.29 a share. Approximately $0.24 of the reduced guidance was from extra fulfillment costs to enable the company to better sell store inventory online and bolster its ship from store capabilities. The remainder of the lower guidance was due to the company being more price competitive to win customers as competitor Gymboree liquidates.

Obviously, investors were disappointed by the lower guidance, but I am looking at the bigger picture. The company continues to grow the top line, with comparable store sales expected to be up by mid-single digits again this year. PLCE also has a strong online presence, which now accounts for 29% of total sales, with a revenue gain of 38% in the most recent quarter. The company is very efficient, with return on assets to approach 15% this year. Share buybacks continue, with total share count down another 9% this year.

Considering all the above, I think it is more than worth buying this strong company as earnings growth pauses for a period of investment. PLCE is a buy below $115. My target is $130.

Company Review

Big Lots (BIG) shares have weakened further from last week’s disappointing third-quarter earnings and poor guidance for the fourth quarter. I am still sticking with the shares for now though, as I feel the string of earnings disappointments is near an end, the stock is selling for just over 8X forward estimates with a debt-free balance sheet. Some unusual factors led to the poor 2018, but now comparisons are much easier in 2019, and there is a lot of good going on under the surface at BIG, such as the strong performance of its new format stores. The guidance for the fourth quarter feels like it has a “kitchen sink” element to it, in which a new CEO looks to clear out old problems to set up the company for better results next year. While the stock may vacillate until guidance for 2018 is given, I expect earnings next year to be slightly better than the $3.60 now expected for this year, even with the company making investments in its highly popular new store format. Buy BIG under $32. My target is $43.

Chubb (CB) announced on Dec. 3 that it expects to incur $195 million in after-tax losses related to California wildfires. The news did not really have much of an impact on the stock, which has been befitting from being somewhat of a safety play among financial shares. At 1.2X book value and 12X next year’s EPS, the stock holds enough value to fight off continued overall market weakness and do well should the market turn around. I will be aware for potential pricing weakness in the property and casualty insurance market, but for now CB is a good by below $130. My target is $145.

Cognizant Technology Solutions (CTSH) had a positive analyst meeting on Nov. 16, with the company forecasting to grow revenues 7% to 11%, close to its historical averages, over the next 3-5 years, as it will continue to expand its digital offering and look to grow outside the United States. Margin improvement will be modest over the same period, helped by opportunistic cost cuts. Approximately 50% of the company free cash flow will go to buybacks and dividends over the same period. The meeting has given some stability to the shares during the rocky market period. CSTH has good growth ahead of it and is very attractively valued at less than 14X next year’s EPS. CTSH remains a buy below $77.50. My target is $100.

DowDuPont (DWDP) appeared to be well on its way to recovery, trading over $60 a share briefly last week before the market pulled back. However, I think this brief rally shows there is a strong upside potential in the shares here once we get positive clarity on tariffs and the 2019 economic outlook, which I feel we will get in the first quarter of next year. With the stock close to a 2-year low despite continued earnings improvement, I believe the risk versus reward characteristics of the shares are favorable. Buy DWDP. My new buy under price is $55 and my target is $65.

EMCOR Group (EME) has incurred recent weakness in its shares but the dip has nothing to do with the company’s recent results and near-term earnings momentum, which remains strong. Macroeconomic concerns are starting to weigh on the stock. Without clear signs the economy is heading into a recession, my inclination is to stick with the shares of this facilities services company, which offer good value at 13.5X 2019 EPS. Buy EME under $72. My target is $82.

First Hawaiian (FHB) has come under pressure, as have other banks, as the yield curve has flattened and raised concerns about the economy in general. I feel as though these fears are overdone, and I look forward to the bank giving clarity to business conditions when it reports earnings in January. Provided no downturn in credit conditions, the company should earn $2.16 a share next year, and the stock is attractive at 12x this estimate with a dividend yield approaching 4%. FHB is a buy below $26. My target is $30.

J.M. Smucker (SJM) reported fiscal second-quarter results and an outlook for the remainder of the year that were not as bad as the market showed. Given the growth in its core businesses, and other negatives like pricing baked into estimates, I do not see any further downside to the company’s $8.00 to $8.20 EPS projections for the April 2019 fiscal year. Just modest growth in the fiscal April 2020 fiscal year should be enough to get the stock going forward again and move closer to my $120 target. Continue to buy SJM under $108.

Morgan Stanley (MS) operates businesses that are market sensitive, so it is not surprising to see the shares not do well in the current climate. However, the market sell-off will not last forever, and the underlying fundamentals of the company’s businesses are strong. Now trading at book value, with a dividend yield of 2.9%, the stock seems to have limited downside barring more significant downside in the market, which I do not foresee currently. Continue to buy MS under $49. My target is $56.

Omnicom (OMC) stock continues to be a standout performer, holding a solid gain since my July 26 recommendation, despite the struggling market. Better-than-expected third-quarter results, combined with the company seeking to cut costs and, most recently, winning a 10-year, $4 billion contract from the U.S. Army, have led to the shares trading firmly. Selling at 13X next year’s EPS with a dividend yield of 3.1%, the stock remains inexpensive, and even modest growth should enable the shares to do well. The stock is well above my $71 buy under price. But I continue to hold to my $80 target.

Valley National Bancorp (VLY) shares have struggled with the banking sector in general. While the flatter yield curve could put some pressure on earnings in 2019, I still expect loan growth to be good, and cost savings from the USAmeriBancorp Inc. acquisition will also support earnings. Trading just over 10X a realistic EPS estimate of $0.92 for 2019, along with a 4.3% dividend yield, 2019 should be a good year for VLY shares, provided the economy remains sound. Buy VLY under $10.50 My target is $13.